Audit: IRS Fails to Collect Interest on Penalties

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The federal government loses hundreds of millions of dollars every year because Internal Revenue Service (search) computers don't record the interest due on penalties for unpaid taxes, a Treasury Department (search) auditor said Tuesday.

But thousands of taxpayers whose accounts are managed by hand, not by computer, do pay the interest. The discrepancy raises questions about how the tax agency meets its mission to apply the tax law "with integrity and fairness to all," said a report by the Treasury Department's inspector general for tax administration, J. Russell George.

"This practice results in inconsistent treatment of some taxpayers who have to pay interest on the penalties," the report concluded.

The inspector general's office, which provides independent oversight of the IRS, studied taxpayer accounts that showed penalties for unpaid taxes in 2002.

Taxpayers must pay the fine, known as a failure-to-pay penalty (search), when they don't meet the deadline for paying taxes. The charge accrues monthly until the taxes are paid or the penalty equals 25 percent of the unpaid tax. The taxpayer also owes interest on the mounting penalties.

IRS computers keep track of the building failure-to-pay penalty, but the charges aren't applied to the taxpayer's account. That means IRS computer systems do not calculate and charge interest owed on the unpaid penalties.

The investigators estimated that the IRS could have charged more than $817 million in interest in 2002 if its computers applied the penalties to taxpayer accounts quarterly.

But some taxpayers do pay interest. The auditors estimated that more than 125,000 taxpayers in special circumstances, whose accounts are tracked by hand, were charged more than $8.7 million in interest through 2003 on penalties applied in 2001 and 2002.

They included taxpayers who got special extensions on tax filing and payment deadlines, such as people affected by natural disasters and military personnel serving in combat zones.

In its response to the Treasury auditors, the IRS said it must follow a law that requires the tax agency to mail a notice each time the failure-to-pay penalty increases in order for the interest to be legally due.

The IRS said it doesn't have the capacity to send monthly notices to taxpayers as those penalties and interest charges accrue. It would also mean a huge volume of telephone calls that would swamp customer service employees.

The IRS agreed to start applying the penalties annually beginning in 2006, which would allow the agency to start recording interest charges on those unpaid penalties. The agency already sends annual notices reminding taxpayers of taxes due.

The Treasury auditors strongly suggested that Congress rewrite the law to allow the IRS to charge interest once a taxpayer has been notified that he owes the penalties for failing to pay without sending additional notices.

Sen. Max Baucus of Montana, the top Democrat on the Senate Finance Committee, said lawmakers should take a look.

"Congress shares in the responsibility to ensure that similarly situated taxpayers are treated similarly," he said. "If we have to clarify the law, then let's do so to maintain the fairness and integrity of our tax system."